There's been very little deleveraging after the last financial crisis and, in fact, debt levels are at new records globally, which means investors should be thinking about the risk of “debtflation,” Russell Napier, editor of The Solid Ground, told FS Insider last week (see Russell Napier on Debt Deflation: Too Much Debt, Not Enough Money for audio).
It isn’t the case that we’ve seen much deleveraging since the financial crisis, Napier noted. Globally, the debt-to-GDP ratio is at an all-time high, he added, significantly above the levels seen in 2007.
Though there has been some deleveraging in the household sector, Napier stated, this isn’t the whole picture. It ignores the releveraging of the government during the last crisis, and also that corporations have been adding significant amounts of debt.
If we look globally, emerging markets are fueling the rise to a new high in the debt-to-GDP ratio. It isn’t just China either, but other countries as well that are responsible for this effect.
“If the world was fragile in 2007 because there was too much debt and not enough GDP, it is significantly more fragile today,” Napier said.
Velocity of Money Falling
Though there is an overall tendency for velocity of money to fall over time, Napier noted, the accelerated decline we’ve seen in recent years is due to the nature of the money that is being created. This money primarily takes the form of bank reserves, which are not inherently fungible and are now stuck in the banking system.
Banks have chosen not to increase the size of their balance sheets and create deposits, which is the money that circulates in the actual economy, as opposed to the asset economy. This is why Napier thinks the velocity of money has fallen.
“There’s a form of money there that is stuck in the ‘asset ghetto,’ if you like, and not yet spreading out to normal GDP,” he said.
This plays in part into the assumption most people make that the world is awash in money. While there is a lot of money in the asset markets, the reality is that M2 growth in the United States is 5 percent, which is one of the lowest levels recorded in the past 30 years, Napier noted. Apart from the 2008 to 2009 crisis, we’re back to very low levels of total money creation.
This is true of other countries, as well. China is close to a new record low in the growth of its money supply. India is also showing levels of growth in its money supply not seen since 1963.
Why We’re Likely Looking at Deflation Ahead
Money supply growth is incredibly low today, and we have virtually no inflation, Napier stated. He’s concerned that a deflationary force can build up in emerging markets, where changes in monetary policy can push linked exchange rates to invoke deflationary forces.
If a country such as China decides to get out of its debt problem by creating more money, more nominal GDP growth, and more inflation, the price paid in terms of its exchange rate is inherently deflationary.
This could lead to another credit crisis, Napier noted.